Practical guidance for companies whose counterparties are experiencing financial difficulty

This Quickguide outlines some practical considerations for companies whose contractual counterparties are experiencing financial distress, including what questions may be asked of the counterparty in relation to its distress and how to negotiate payment terms or recover debts.

1. Overview

Financial difficulty can manifest itself in many different ways, including short-term or long-term issues, operational or financial issues, cash flow or balance sheet problems.  Common to all financial distress related issues however is the additional workload, responsibilities and pressure it exerts on the company's directors.

When a company is experiencing financial difficulty, certain of its directors' statutory duties are modified and additional duties may apply.  In particular:

• the directors may be under an obligation to take into account the interests of the company's creditors in addition (and sometimes in priority) to those of the company's shareholders; and
• directors may also be under an obligation to avoid wrongful trading, which requires directors to take every step with a view to minimising potential loss to the company's creditors.

If the directors consider that the company is or is likely to become "cash flow" insolvent (i.e. unable to pay its debts as they fall due) or "balance sheet" insolvent (i.e. the value of its assets is less than the value of its liabilities, taking into account contingent and prospective liabilities), they may be advised to place the company into an insolvency process.  Against this backdrop, parties contracting with a company in financial difficulty ought to consider taking certain practical steps in order to understand the financial position of the company and to protect their own position.

There are a number of practical steps that can be taken in the event that a contractual counterparty experiences financial difficulty.  Maintaining good relationships with the counterparty's directors, facilitating an open dialogue and acting early are key to increasing the likelihood of a good outcome for parties contracting with a company in financial distress.

2.  Questions to ask/consider about the financial distress

What is the nature of their financial distress? It may be possible to discuss the financial position of the company with its directors.  You can run searches of public registers, including The Gazette, Companies House and the Central Registry of Winding-up Petitions which may also provide information relating to the company's solvency status.  Consider:

• Are any mitigating measures available to relieve the financial pressure? Has the company already begun implementing such measures?
• What is the liquidity position and cash runway of the company?
• What is the likelihood of the company avoiding an insolvency or, if that is not possible, how imminent is insolvency?
• Are creditors threatening to take action against the company?
• What is the position of any credit insurers?
• Has the company considered any contingency plans and, if so, what are they?
• Has the company engaged financial and/or legal advisers?

3.  Dealing with the company in distress

Communication: decision-making is undertaken by a company's board.  Parties contracting with a company in financial distress should ensure that there is an open channel of communication with the relevant decision-makers.

Credit control: parties contracting with a company in financial distress should ensure that credit does not build up.

Retention of title: suppliers may seek to protect their retention of title position when contracting with a customer in financial distress by, for example, reviewing any contractual retention of title provisions and, if necessary, communicating to the company that title to the relevant goods remains vested in the supplier until its contractual obligations are fulfilled.  This is an important protection and care should be taken to ensure notification is promptly and accurately communicated. 

Continuation of supply: a supplier company may struggle to continue performing its contractual obligations and providing goods.  In those circumstances, parties should consider seeking an alternative supplier in order to ensure continuity of supply.

4.  Negotiating payment terms and recovering debts

Without prejudice discussions: if a company in financial distress is experiencing cash flow or balance sheet issues, without prejudice discussions regarding payment may be helpful (for example, over what period of time can the company make payments and can it (i) pay in instalments; (ii) make a bullet payment; or (iii) receive a discount for early payment?).  In these circumstances, parties contracting with a company in financial distress ought to see evidence of the financial position of the company in order to find out what other outstanding debts it may have and any payment plans for such debts, to avoid other creditors being paid earlier.

Without prejudice letter: separately to any without prejudice discussions (or additionally), parties may consider sending a without prejudice letter to the company in financial distress enclosing an offer for delayed or reduced payment alongside the demand for the amount due (setting out the payment plan in a simple letter format that can be signed and returned promptly).  Any discussions prior to an actual agreement ought to be on the basis that the creditor's existing rights are reserved.

Security: parties may consider whether there is a way in which they could obtain any form of security for payments that are rescheduled with a company in financial distress (although it may not be easy to take robust security against such a company).

Documentation: parties should consider the ways in which agreements with a company in financial distress ought to be recorded.  For example, it may be simpler to enter into a new agreement that acknowledges the amount due and sets out the agreed payment plan, which can be enforced as a simple debt claim in the event of a breach and which makes it easier to issue a statutory demand (noting the associated reputational/relationship issues), obtain summary judgment or negotiate with officeholders if necessary.  Note that some transactions that are entered into prior to the insolvency of a company in financial distress may unfairly disadvantage other creditors and may be voidable if the company enters into an insolvency process (for example, preferences).

Breach: consider potential courses of action in the event that the company in financial distress breaches its contractual obligations.  It may be possible to act quickly in order to obtain some monies prior to its entry into an insolvency process (for example, by agreeing a renegotiated payment plan).  In these circumstances, issuing a statutory demand and/or threatening a winding up of the company can be the most powerful weapon available to a creditor.  In the absence of a statutory demand parties may be able to achieve the same result by relying upon goodwill, depending on the strength of the relationship with the company in financial distress.  Note that the issuance of a winding up petition can accelerate the entry of the company into an insolvency process which may not always be the desired outcome.  Litigation is unlikely to be the most efficient route for seeking to recover any monies in relatively quick order.

Officeholder: in the event that the company in financial distress enters into an insolvency process, the officeholder (for example, the administrator or liquidator) will be responsible for management of the business.  Facilitating an open dialogue with the officeholder in those circumstances is therefore beneficial and should be undertaken as early as possible including pre-appointment.